Monday, August 22, 2005

Who Pays for the Lawyers When Accounting Fraud Hits the Company?

When a company and its senior executives are caught up in a government investigation, it sometimes seems like an invitation to a Lawyers Full Employment seminar because of the number of fronts on which the company has to fight, and the number of lawyers that have to be hired for individual officers, directors, and employees to represent their interests in the various forums.  The source of the payment for all these lawyers is the company, assuming it is not in bankruptcy and unable to pay its bills.  A recent unpublished decision by the Ninth Circuit heightens the financial risk to companies when officers engage in accounting fraud.  In Federal Insurance Co. v. Homestore, Inc. (available here),  the court upheld the grant of summary judgment to a group of insurance companies that had underwritten the Directors & Officers (D&O) policy for Homestore.Com, which changed its name to Homestore, Inc. after a major accounting investigation.  In 2002, Homestore's then-CFO, Joseph Shew, and other former officers entered guilty pleas to conspiracy to commit securities fraud  related to overstatements of the company's advertising revenue (that whole darn round-trip transaction problem, involving matched orders, etc.).  Homestore settled the SEC action and restated its revenue and income for the relevant period.  With the multiple investigations of the company, a number of officers were represented by counsel, and Homestore sought reimbursement of the costs of representation and settlement amounts from its various D&O insurers.  In an aggressive move, the insurance companies filed a declaratory judgment action because, in its application for insurance signed by Shew, Homestore attached a copy of its 10-Q and 10-K filings that contained the accounting misstatements.  The district court held that the materially false statements submitted by the company meant the D&O policies could be rescinded.  Importantly, the district court held, and the Ninth Circuit affirmed, that the rescission applied to both guilty officers (i.e. Shew) and  "innocent" directors and officers who had no knowledge of the accounting fraud.  This means that Homestore, and not its insurers, is on the hook for the attorney's fees and costs of settling the various cases.

Can the company avoid having to pay all those attorneys?  Under corporate law, a company can indemnify officers and directors for their costs, including attorney's fees, incurred in investigations and litigation related to their conduct on behalf of the company.  In fact, most corporations have broad  indemnification provisions, including advancement of such costs if the officer makes a good faith representation to repay the costs if it turns out the officer is not entitled to the payment of expenses.  Like the D&O insurers, companies will sometimes seek to avoid payment under indemnification provisions in the Articles and by-laws, but they have received much less favorable treatment in the courts, particularly the Delaware Chancery Court.  In Tafeen v. Homestore, Inc., arising out of the same set of investigations, Delaware Chancellor Chandler rejected Homestore's attempt to avoid advancing attorney's fees to an officer caught up in the investigation.  The Chancellor's opening paragraph (here) in one of the many opinions generated in the case summarized his view of the company's argument seeking to avoid payment of the fees:

This is yet another case seeking advancement or indemnification of legal expenses, in this instance brought by a former officer of a Delaware company who is a defendant in multiple legal proceedings. What is unusual about this advancement case is the company's novel defense: it contends (among many other things) that the former officer is not entitled to advancement because he has offered a hollow, worthless promise to repay if he is ultimately found not to be entitled to indemnification. The defense is novel because it reminds one of a sinner who suddenly finds religion-the conversion is breathtaking. Content to adopt advancement and indemnification bylaws drafted with holes large enough to drive a truck through, the defendant company (like so many others in this Court of late) suddenly "finds religion"-insisting on a rigorous interpretation of its loosely written bylaws.

Corporations  involved in accounting investigations, such as Krispy Kreme, Delphi, and AIG, face civil and criminal investigations, along with shareholder derivative suits and securities class actions, and know that the meter on attorney's fees shoot up like it's spring-loaded.  Now, the ostensible protections of the D&O policies, including the highly valuable "duty to defend" provisions, may get yanked away.  If the officer is successful in defending a case, such as Richard Scrushy of HealthSouth, then the company is required to pay for the attorney's fees.  For officers and directors involved in such cases, the continued existence of the company is their only hope of having attorney's fees reimbursed if the insurance disappears. If the company goes bankrupt, they can be left to fend for themselves, and we know the lawyers do not come cheap. (ph)

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Civil Enforcement, Fraud, Investigations, Judicial Opinions, Prosecutions | Permalink

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